What Will Replace China's 'Insane' Circuit Breaker?

Friday, the South China Morning Post reported that most stock market analysts believe the China Securities Regulatory Commission will put in place another “circuit breaker” to limit volatility on the Shanghai and Shenzhen exchanges.

Any new circuit breaker, no matter how well crafted, will not work well in the troubled period that is immediately ahead. Chinese stocks are substantially overvalued, and the adjustment downward will therefore be especially difficult.

The CSRC suspended its circuit breaker—“index fuse mechanism” in its lingo—after the close of trading Thursday. The measure was in place for only four days, Monday through Thursday.

The circuit breaker, while in effect, suspended trading for 15 minutes if the CSI 300 Index moved 5%, up or down, during a day. It then suspended trading for the remainder of the day if the index hit 7% after the “cooling off” period.

There were vociferous complaints about the circuit breaker after the close of trading Thursday, and in fact there was a lot of time to grouse. Thursday, in fact, was the shortest trading day in the history of the People’s Republic, 29 minutes to be exact. The market dropped 5% in the first 13 minutes after the 9:30 A.M. opening. Then, after the 15-minute suspension expired, it fell another 2% in a minute. Trading, therefore, was frozen for the remainder of the day at 9:59. As Bloomberg noted, if you blinked, you missed the trading day.

Before the CSRC took it down, the circuit breaker stopped trading for the day on Monday as well.

Market drops during the four trading days it was in effect wiped out 7.05 trillion yuan ($1.1 trillion) of value.

The CSRC did not give an indication how long the suspension would last, but no one thinks the circuit breaker will come back in its present form. Thursday’s session was a debacle. “This is “insane,” Chen Gang of Shanghai Heqi Tongyi Asset Management told Bloomberg.

Chen should know. Because of the circuit breaker, he had to sell on Thursday all $46 million his firm had under management. The mechanism accelerated selling pressure, and many managers then had to dump holdings due to stop-loss agreements with investors. As a fund manager quoted on the Zero Hedge site said, “It couldn’t be worse.”

There is no mystery how Beijing designed what is surely the worst circuit breaker in history. The CSRC, it appears, came up with the idea as a way to limit not volatility but to stem losses during the sickening stock market slide beginning in mid-June. As such, it was a part of Beijing’s draconian measures that were roundly condemned in China and abroad.

The CSRC on September 6 announced a study of a circuit breaker and on the following day said that the consultation period would last two weeks. There was little opposition, at least expressed in public. The authorities at the time were—as they are doing now— detaining market participants, creating a climate of fear.

The South China Morning Post identified only Blake Zhang of Deutsche Bank as opposing the concept in public, but he worked in New York, safe from Chinese officials. “There was not a single piece of commentary challenging the new policy,” the Hong Kong paper noted.

Within a day of the end of consultation period, state media reported that the CSRC would promulgate such a mechanism. As the Post perceptively noted, the circuit breaker was “a mirror of China’s political scene.”

There is some hope for the future, however. The CSRC, in response to a reporter Thursday, stated that it will evaluate the first plan, study the matter in general, and consult with stakeholders.

As a result, a new circuit breaker will undoubtedly come back improved. It will, for one thing, incorporate a wider trading range. Brett McGonegal of Reorient Group thinks the limit should be 15% instead of 7%. And he has another suggestion: the trigger should not be “price based” but “volume based.” In other words, limits breached in thin trading should be ignored. Both of his recommendations, of course, make sense. The first will certainly be incorporated in a new circuit breaker, and the second should be.

Yet it may not matter how well conceived any new mechanism will be. The overriding reality is that Chinese stocks, despite the carnage in the markets last week and last year, are still overvalued.

And the overvaluation is not insubstantial. The median Chinese stock listed on the Shanghai and Shenzhen exchanges is trading at over 60 times earnings. That is more than three times the median multiple of stocks on the New York Stock Exchange. In India, a country with far better growth prospects than China, the average multiple is under 25.

Moreover, the Chinese economy is trending downward fast, which means stocks prices should tend to fall quickly, even in the unlikely event that stocks can keep their current multiples. Moreover, money is gushing out of the country and the currency is falling fast, so the Chinese will be looking to unload Shanghai and Shenzhen stocks.

The only countervailing trend is that Beijing is still committed to keeping the markets high and will be continuing its top-down tactics to prevent selling, like employing the so-called “National Team” of state and state-controlled entities to buy stock, criminalizing various forms of selling, forcing institutions to hold shares, and detaining market participants. These tactics have worked for about a half year, but no government—not even one as determined as China’s—can overcome market forces in the long run.

Beijing will probably take a long time to devise the replacement circuit breaker. Xiao Gang, the chairman of the CSRC, is taking heat for the losses last week and may lose his post.

That means whoever heads the Commission is going to make sure the new circuit breaker has support among all power brokers in Beijing as well as traders, and that ensures the negotiations over the measure will be lengthy.